How does an Annuity Work

An annuity is a contract you make with an insurance company, the main advantage of which is tax-deferred growth of earnings.  Annuity contracts are issued by life insurance companies.

In the deferral phase of an annuity, you deposit and accumulate money.  This can take either the form of a lump-sum payment or a series of payments.

There are two main types of annuity.  With a fixed annuity, you receive a certain guaranteed rate of interest.  With a variable annuity, you choose how to invest the money – most commonly in a mutual fund – and that determines your return.  Variable annuities are higher risk/higher reward, clearly more of a “gamble.”

A fairly new kind of annuity, called an equity-indexed annuity or fixed indexed annuity, is something of a hybrid of a fixed and a variable annuity.  With this kind of annuity, the insurance company guarantees a certain minimum return, with the precise amount being determined by the movement of an equity index, such as the Standard & Poor’s 500.

Variable annuities are securities and are regulated by the Securities and Exchange Commission (SEC).  Fixed annuities are not.  Equity-indexed annuities depend on the precise mix of features, but more often they are not classified as securities that come under SEC jurisdiction.

In the income phase of an annuity, the insurance company makes periodic payments to you, which can be for a definite period of time, such as ten years, or for an indefinite period of time, such as the remainder of your lifetime, unless you choose to receive your contract value in a lump sum.  And in fact, annuities nowadays more often do pay out in a lump sum, rather than being used to provide a guaranteed income for life.

An annuity will also sometimes provide a benefit to your beneficiary upon your death, which is closer to what one would expect from a form of life insurance.

States regulate life insurance companies, and states regulate annuity contracts, so what is allowed and precisely how they work varies from state to state.  The tax treatment of annuity contracts, however, is a federal matter, governed by the Internal Revenue Code.

Annuity contracts tend to come with high sales commissions, averaging 6%, ranging from 1% to 12%.  This is certainly a factor for consumers to be aware of, as shopping around may mean a much lower commission.  It can be a little tricky, because the commission is usually “hidden,” in the sense that the consumer doesn’t pay it directly.  The insurance company pays it, but then will accordingly boost its fees to the consumer or lower the return rate of the annuity.